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Costs of Equity Capital and Model Mispricing

Authors

  • Ľuboš Pástor,

    1. Wharton School, University of Pennsylvania
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  • Robert F. Stambaugh

    1. Wharton School, University of Pennsylvania and the National Bureau of Economic Research
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    • Pástor is at the Wharton School, University of Pennsylvania and Stambaugh is at the Wharton School, University of Pennsylvania and the National Bureau of Economic Research. The authors are grateful for helpful comments by Wayne Ferson, Craig MacKinlay, René Stulz, two anonymous referees, and seminar participants at Harvard University, the National Bureau of Economic Research, New York University, the University of Pennsylvania, the University of Toronto, Virginia Polytechnic Institute, and the 1998 meetings of the Western Finance Association and the European Finance Association. Stambaugh acknowledges financial support provided during his appointment as a Marvin Bower Fellow at Harvard Business School, where portions of this research were conducted.

Abstract

Costs of equity for individual firms are estimated in a Bayesian framework using several factor-based pricing models. Substantial prior uncertainty about mispricing often produces an estimated cost of equity close to that obtained with mispricing precluded, even for a stock whose average return departs significantly from the pricing model's prediction. Uncertainty about which pricing model to use is less important, on average, than within-model parameter uncertainty. In the absence of mispricing uncertainty, uncertainty about factor premiums is generally the largest source of overall uncertainty about a firm's cost of equity, although uncertainty about betas is nearly as important.

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